Question

USE THE INFORMATION BELOW TO ANSWER THE FOLLOWING 4 QUESTIONS

Erma’s Beauty Supply is considering expanding the existing store. Erma wants to lease the office space next door to her business. Erma must spend, $120,000 on equipment to expand. The equipment is expected to have a zero-salvage value and will be retired in 8 years. Erma expects to increase networking capital by $8,000 right now if she goes through with the expansion. Erma spent $12,000 last month on a survey of the area surrounding the shop to see if there was sufficient demand for a larger store. Erma estimates she will increase revenues by $110,000 per year in the new store for eight years. The direct expenses incurred to make those sales are $78,000, including rent. The lease she is considering signing is for 8 years. She will liquidate the $8,000 networking capital when the lease is complete in 8 years. Erma’s Beauty Supply pays 40.0% in taxes and has a cost of capital of 9.0%.

38. How much does Erma need to expand her business at T=0?

39. Based on this information, the project’s operating cash flow in each of the first seven years is $_______?

40. Based on this information, the project’s terminal year (year 8) total cash flow is $_______?

41. What is Erma’s NPV if she decides to expand the business?

Answer 1

38. How much does Erma need to expand her business at T=0?

C₀ = Equipment cost + investment in working capital = $ 120,000 + 8,000 = $ 128,000

39. Based on this information, the project’s operating cash flow in each of the first seven years is $_______?

No information on the depreciation is given We assume depreciation is on straight line basis.

Annual depreciation = 120,000 / 8 = 15,000

OCF = (Revenue - Costs - Annual depreciation) x (1 - Tax rate) + Depreciation = (110,000 - 78,000 - 15,000) x (1 - 40%) + 15,000 = $ 25,200

40. Based on this information, the project’s terminal year (year 8) total cash flow is $_______?

Terminal year cash flow = OCF calculated above + release of working capital = 25,200 + 8,000 = $ 33,200

41. What is Erma’s NPV if she decides to expand the business?

NPV = - C₀ + OCF / r x [1 - (1 + r)^-n] + Release of working capital x (1 + r)^-n = -128,000 + 25,200 / 9% x [1 - (1 + 9%)^-8] + 8,000 x (1 + 9%)^-8 = $ 15,492